Taking a Tax Bite Out of Bitcoin

Do states and localities have a revenue interest in virtual currencies?

Getting a handle on the virtual currency Bitcoin is no easy task: Is it truly a currency? Or is it something else, like a capital asset? These are the questions the Internal Revenue Service (IRS) is mulling over. Its decision -- and don't expect one soon -- carries tax implications for states and localities.

Created by anonymous Japanese computer programmers in 2009, Bitcoin was intended to serve as an alternative to national currencies. The coins are worth what the market is willing to pay for them. There are other alternate digital currencies out there -- including Litecoin, Peercoin, Ripple and Coinye West (rapper Kanye West's lawyers have sent a cease and desist order to stop use of the name though) -- but it's Bitcoin that's best known and has put virtual currencies on the radar of some very big institutions.

Last November, Fed Chairman Ben Bernanke noted in a letter to senators that the Federal Reserve Bank doesn't have the authority to supervise virtual currencies, but that it would "continue to monitor developments as part of its broad interest in the safety and efficiency of the payment system." The Securities and Exchange Commission (SEC) has been asked to okay an exchange-traded fund (ETF) for Bitcoins. It would be the first ETF to track a virtual asset; the funds usually track securities such as stocks and bonds or commodities such as gold and oil.

To explore the implications of Bitcoin on states and localities and their tax systems, I caught up with Howard Gleckman, resident fellow at the Urban Institute and editor of the institute's blog TaxVox. What follows is a condensed transcript of our conversation. edited for clarity.

What is the federal government doing about Bitcoin?

The basic question the feds will have to answer is whether Bitcoin is a currency or a capital asset. The answer to that question will determine its tax treatment. As a capital asset, Bitcoin is subject to capital gains taxes; as a currency, it's subject to ordinary income taxes. The fundamental question seems to be: If you are going to define something as a currency, is it in common use or general use in commerce? At this point, the answer to this for Bitcoin is no -- at least for now.

So how does that affect taxes?

If it is decided that it is a capital asset, the good news for those who hold Bitcoins is that the rate is lower than on ordinary income (23.8 percent for high-income taxpayers). The bad news is that they can only deduct losses against ordinary income up to $3,000. Bitcoin value is so volatile that this could be an issue for someone who has losses. The investor would have to figure out the basis by tracking very closely what the Bitcoin was worth when acquired and what it was worth when the investor disposed of it -- and pay the tax on the difference.

One last issue on the question of disposition of Bitcoin: Is it a taxable event subject to income tax when you acquire something with Bitcoins? That's something people haven't figured out. If someone acquires Bitcoins for $400 and buys something for $500, is that $100 difference subject to capital gains taxes.

Are there issues that affect states directly?

The issue closer to the states is, do you owe sales tax if you buy something with Bitcoin? The answer clearly is yes. The retailer is responsible for collecting and remitting a sales tax on a Bitcoin transaction as if it were in dollars. But it requires an extra step on the retailer's part. No state governments would accept Bitcoins, so the retailer would have to translate the value of Bitcoin into dollars and remit the sales tax in dollars.

As to income taxes, when the IRS provides some guidance, I would expect states to piggy back on that.

Should states be taking any action on the sales tax issue?

States may want to clarify things, but it's a fairly clear cut issue that the retailer has to collect sales tax and then remit to the taxing authority in dollars. If Bitcoin is used, it is up to the retailer to mark to market on the day of the transaction. Otherwise the retailer can get caught up in a difficult situation -- by the time it makes a calculation, the Bitcoin may be worth a lot more or less than it did when the transaction occurred.

Would an SEC decision on an exchange-traded fund affect tax rulings?

If the SEC approved an ETF, an investor would be purchasing not the actual Bitcoin but the daily value. Whether the SEC will approve it is not clear. The fact that you have a request to create a fund based on the value of these things does force regulators and the IRS to make some decisions about what this is. So the Winklevoss brothers [Internet entrepreneurs turned venture capitalists], who have made the request to the SEC, have said they would treat it as a capital asset. I'm speculating that their lawyers told them that it would be very, very hard given the very limited usage of Bitcoins to credibly claim this is a currency.

What's so interesting about Bitcoin is not its lack of a sovereign basis -- in theory you could have something that wasn't a sovereign currency. The test is not who issues it but who accepts it. Right now, it's a curiosity among most people -- not a full blown currency.

Again, the last word on this would be the SEC on the regulatory side and the IRS on the tax side.

Should Bitcoin and other digital currencies be on state legislators' watch list?

At this point they should be aware of and recognize the tax consequences. There will certainly be in almost every state some Bitcoin transactions, and it probably doesn't hurt to remind retailers of their obligations. It might not hurt to also hold a hearing and bring in some tax experts to talk about the consequences.